๐ Short-Run Costs
The short run: The short run is a time period in which at least one factor of production is fixed (typically capital โ factory size, machinery). Only variable inputs (labour, raw materials) can be changed.
Types of cost
- Fixed costs (FC).
- Variable costs (VC).
- Total cost (TC).
Per-unit (average) costs
- Average fixed cost (AFC) = FC รท Q โ falls continuously as output rises (spreading the overhead).
- Average variable cost (AVC) = VC รท Q โ U-shaped due to diminishing marginal returns.
- Average total cost (ATC).
Marginal cost
Marginal cost (MC): Marginal cost. MC is the most important cost curve โ it drives all profit-maximisation decisions.
Key curve relationships: MC cuts AVC and ATC at their minimum points. When MC < ATC, ATC is falling; when MC > ATC, ATC is rising. Think of it like exam averages โ one bad test (high MC) pulls your average up.
๐๏ธ Long-Run Costs
The long run: The long run is a time period in which all factors of production are variable. The firm can change its plant size, number of factories, and entire scale of operation. There are no fixed costs in the long run.
The long-run average cost (LRAC) curve
The LRAC curve is an envelope of all possible short-run ATC curves โ it shows the lowest average cost achievable for every level of output when the firm is free to choose any plant size.
Three regions of the LRAC
- Economies of scale.
- Constant returns to scale โ a range where LRAC stays flat as output increases. Doubling all inputs exactly doubles output.
- Diseconomies of scale.
Minimum efficient scale (MES)
MES: Minimum efficient scale.
Industries with high MES (e.g. aircraft manufacturing, utilities) tend to be oligopolies or natural monopolies. Industries with low MES (e.g. restaurants, hairdressers) have many small firms.
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๐ Diminishing Returns vs. Economies of Scale
Students often confuse these two concepts. Diminishing returns is a SHORT-run concept (adding more of a VARIABLE factor to a FIXED factor). Economies of scale is a LONG-run concept (increasing ALL factors of production).
The law of diminishing marginal returns
As more units of a variable factor (e.g. workers) are added to a fixed factor (e.g. capital), the marginal product of the variable factor eventually falls. This causes MC to rise and gives the SR cost curves their U-shape.
Comparison table
- Diminishing returns โ short run โ at least one fixed factor โ explains U-shaped MC and ATC.
- Economies of scale โ long run โ all factors variable โ explains downward-sloping LRAC.
- Diseconomies of scale โ long run โ all factors variable โ explains upward-sloping part of LRAC.
- A firm can experience BOTH simultaneously: diminishing returns in its current factory (SR) while still benefiting from economies of scale if it built a bigger factory (LR).
Exam technique: If a question says 'explain why costs rise as output increases', check the time frame. Short run โ diminishing returns. Long run โ diseconomies of scale. Don't mix them up!